Over the last few days, there has been a lot of buzz around social media businesses fetching insanely high valuations including Facebook’s acquisition of WhatsApp for $19 billion. On one hand, the conservative traditional investors are perplexed with the high valuations of social media companies, on the other hand some traders with investments in social media are laughing their way to the bank.

The fact is that ‘Social Media’ businesses differ from ‘Traditional’ Businesses both in terms of ‘Value’ they create and in terms of the methods used for ‘Valuing’ these companies.

While products and services of traditional businesses serve tangible needs of the market, digital social businesses mostly create new needs either by enhancing user experience, or by seducing users with an unique experience or an emotional appeal.

Traditional businesses generally have a fixed organization structure, start from a local market and later expand to global markets. In contrast, digital/social businesses are global from day one and thrive on collaborative structures based on interaction with online communities; if such companies manage to capture imagination, growth can be instantaneous. Candy Crush, the mobile phone game has been downloaded more than 500 million times since its launch in 2012 and is worth $5 billion now in 2014.

So whilst traditional businesses focus on break-even and profits, for digital businesses expanding and owing the Network becomes the first and foremost priority. The ‘value is in the network’: own the network first, and find a way to profit from those connections later.

For traditional companies valuations are obtained by appropriating all the potential earnings of the company in future to the present date. The future earnings are found based on the growth estimates of the revenue & costs.

For digital companies the valuation is guided by the user base and is based more on the intangible assets. Hence the digital businesses continuously strive to improve user engagement and grow the user base. Though it is possible to attain a spectacular growth in user base within a very short period, say with a particular app, it might be difficult to maintain that level or replicate a similar level of engagement with another app.

Twitter saw the share price plummet more than 20% after quarterly results in Feb 2014, showed that the social network was not adding users as fast as it once did. Zynga, the maker of Farmville, has seen its share price halve since its late 2011 initial public offering (IPO), while Finland’s Rovio has struggled to replicate the success of its 2010 hit Angry Birds.

Secondly valuation of intangible assets in digital businesses requires understanding the full global potential of the assets and valuing them accordingly.

Facebook is currently being valued at $170 billion, at about $130/user, given their existing user base of 1.25 billion. The high price of $19 billion that Facebook paid for acquisition of WhatsApp a co with no (proprietary) intellectual property, almost unlimited competition can perhaps be explained in terms of the strategic value that FaceBook sees in owning a IM service with 450 million users and killing the potential competition.

Had WhatsApp listed on a stock exchange, it possibly might have fetched a lower price.

As it may be difficult for digital businesses to continuously dish out products one after the other, so it is very likely that after having accumulated a user base, the founders of some of the smaller digital businesses opt for selling their product to a bigger player who sees strategic value in the product and can leverage the digital platforms to provide value added services to their customers.

It could also happen that in a year or two from now that social media companies see a deceleration in the exponential growth in user engagement and valuations of these companies come down to more realistic levels commensurate with their earnings and return on investment. In such a scenario, the investors who are late entrants and buy at peek valuations may suffer if the market stops seeing the same potential or prices the companies differently than how the initial price is arrived at.

However a fact that seems almost certain is that with time most of the traditional businesses will work on their digital strategies and start using digital channels to tap the ecosystem & engage online communities. This in turn will benefit the digital businesses that can extend their platforms to individuals as well as to the corporate sector and enter into a symbiotic relationship with the traditional businesses.

The Facebook-WhatsApp deal is a consummation of what I call “Grow first, Profit later” kind of companies. Incidentally, since both of them are in the same category, the deal went through at such a absurd valuation in the first place. This kind of madness is partly reminiscent of the IT boom at the turn of the century. Anyone and everyone was floating an IT company that time and hoping to cash it in quickly (and many did). The same is happening with social/digital medial companies now. If you want to forecast how this madness will end, just go back in history and read about how the IT boom ended!

After all Facebook, is playing not with its own money, but with its shareholder’s money. So they really do not care. It is their shareholder’s who have been taken for a ride. The most famous exponent of this “Grow first, Profit later” motto was Amazon. It is still around today after making losses for many years altogether and continuously eroding shareholder wealth. After over 10 years of existence, last quarter Amazon reported net profits of $240mn on revenues of $25.6bn for a Net Profit Margin of less than 1%! Compare that with the traditional IT companies running sustainable businesses such as Oracle, IBM, Microsoft and even Yahoo, whose NPMs are in the mid to high 20s. If Amazon is still not able to make sustainable profits after more than 10 years of existence and having captured most of the market, do you still want to believe that this motto will work for other wannabes? Investors in such companies are classic examples of “Motley Fools’, a term used commonly in the investing world to describe people who make money by passing the ‘hot potato’ to the next gullible investor. Guess what, in this game the last person holding the potato pays, and pays big-time for his/her greed.

Owning the Network is mistakenly considered as an invaluable Intangible asset by many. But in my book, an intangible asset can be considered an asset in the first place ONLY if that asset is generating income. Without that, it is nothing but an Intangible LIABILITY, which is being financed using shareholder’s money.

Investors need to beware of absurd deals based on misleading concepts !

Thanks Abhijit for highlighting a very valid point. Paying for the deal with stocks instead of cash reduces the risk for Facebook but if the intangible asset turns out to be an intangible liability, then the shareholder who bought the FB stocks at a high price will be taken for a ride.